(TeachMeFinance.com is intended for educational purposes only. TeachMeFinance.com is an informational website, and should not be used as a substitute for professional financial, legal or medical advice. Please contact your attorney or accountant before making actual investment decisions. Also please read our disclaimer.)

During the technology market booms of the 1990’s, the phrase “initial public offering” (IPO) became very common. Each day there seemed to be a new announcement of a Silicon Valley millionaire cashing in an IPO. This period in time also created the term “siliconaire” to refer to the young entrepreneurs who were becoming very rich as a result of their dotcom company IPOs. In this lesson we will discuss the meaning of an IPO; how they have been used to create personal profits; and how individuals go about getting an IPO.

What is an Initial Public Offering?

Selling Stock

When a company first sells its stock to the public it is known as an IPO. The two primary ways that a company can raise money is by issuing equity or debt. When they issue equity to the public for the first time, it is called an IPO.

Companies can be classified as being either private or public. A private company typically has less shareholders and the owners of the company are not required to disclose as much company information. It is possible for anyone to incorporate a company. All that is required is contributing the initial capital, filing the correct documents and following the relevant reporting rules. The majority of small businesses are private companies, but some very large companies including Hallmark Cards and IKEA are privately held.

Typically, it’s not possible for investors to purchase shares in a privately held company. If they want to invest in a company, an investor can ask the owners of the company, but there is no obligation to sell. Public companies differ from private companies primarily because public companies have already sold shares to the public and these shares are being traded on a stock exchange. For this reason, it is commonly said that when a company issues an IPO they are “going public”.

A public company will generally have a large number of shareholders (into the thousands), and must comply with strict regulations. Each public company must report particular financial data on a quarterly basis and are required to have a board of directors. Their financial information is reported to the Securities and Exchange Commission (SEC) in the United States, and to similar governing bodies in other countries. Stock in a public company is traded on the open market, making it very exciting for investors. As long as an investor has the cash, they are able to invest in the company. There is nothing that anyone involved in the company can do to prevent an investor from purchasing company stock.

Why do Companies go Public?

The main reason for companies to issue an IPO is to raise a lot of money. There are a lot of other financial advantages associated with going public. These include:

It is possible to get better rates when the company issues debt. A public
company has higher levels of scrutiny and is a better credit risk.

The ability to issue more stock when there is a sufficient level of demand
makes it easier for a public company to engage in mergers and acquisitions
because the deal can include issuing stock.

Open market trading increases liquidity. It makes it easier to attract employee talent by using incentives such as an employee stock ownership plan.

Being traded on one of the major exchanges provides a lot of prestige for a company. Previously, it was quite difficult for private companies to qualify for an IPO. They needed strong fundamentals in order to be listed. The dotcom era changed this situation and it became much easier for companies without a strong history or financial records to issue an IPO. At this time, IPOs began to be issued by small startup companies that were trying to expand. One of the problems was the fact that a lot of these companies had not yet profited from their business and t weren’t planning on producing a profit in the near future. Many of these companies were based on funding from venture capital. They created excitement in the market for their company, only to spend all the cash, and have the company collapse. In some cases, there is a suspicion that the public offering was for the sole purpose of making money for the owners. This is commonly referred to as an “exit strategy”, which suggests that the founders have no intention of making the company profitable for investors. In these cases, the IPO signals the end, not the beginning, of the company.

It may seem wrong that this can be permitted to happen, but remember that going public is really all about the sale of stock. If a company is able to convince investors to purchase their stock, it will be able to raise a considerable amount of cash from an IPO.

Becoming Part of an IPO

Underwriting

Becoming part of a popular, new IPO can be an extremely difficult task. The first step in understanding how this happens is to understand the way that an IPO takes place. This is referred to as “underwriting”.

The initial thing that a company needs to do to become public is to engage an investment bank. In theory, it is possible for a company to sell its own shares but, in reality, an investment bank is always used. The term “underwriting” refers to the way that a company can raise money by issuing debt or equity (with an IPO we are talking about the issue of equity). The underwriters are the investment banks that act as middlemen between the company and the investors. The largest investment banks involved in underwriting include: Merrill Lynch, Goldman Sachs, Credit Suisse, Morgan Stanley and Lehman Brothers.

The investment bank meets with the company to work out the terms of the deal. The issues to be resolved at this point generally include the amount of money to be raised; the security type that the company wants to issue; and the other details of the agreement. There are many ways that the deal can be arranged. One way is known as a “firm commitment” which involves the underwriter guaranteeing their purchase of the complete offer. They will then sell it to the public ensuring that the company raises a specific amount. Another type is a “best efforts agreement” in which the underwriter sells the stock on behalf of the company without making any guarantees of the amount that will be raised. It is also common for investment banks to work together to create a syndicate of underwriters to avoid taking on all of the risk involved in an IPO. A syndicate will typically involve one leading underwriter and several others that work to sell a portion of the offer.

When the company and the underwriter(s) agree on the terms of the deal, the underwriter completes the registration statement that is required to be filed at the SEC. The registration statement includes the details of the offer and relevant company information, including financial statements, the planned use of the new funds, background on the management, details of any legal problems and insider holdings.

There is a mandatory “cooling off period”, during which time the SEC will investigate the company and ensure that they have disclosed all required information. If everything is in order, the SEC will approve the offering and set the date (known as the “effective date”) that the stock will go on offer to the public.

The underwriter works during the SEC’s cooling off period to create an initial prospectus that is commonly referred to as the “red herring”. This contains all the relevant information about the offer and the company, except the effective date and the offer price as this information is not yet known. The company and the underwriter use the red herring to start to build hype about the offer. They take the red herring on tour (often referred to as a “dog and pony show”), to generate interest from large institutional investors. After the effective date has been set, the company and underwriter will discuss and set the offer price. This can be a very difficult task and will be based on the current level of interest in the offer and the condition of the market at that time. It is obviously beneficial for both the company and the underwriter to set the price as high as possible.

The final step in this process is the sale of securities on the stock market and the collection of money from new investors.

How can people get involved?

As discussed above, underwriting an IPO is a complex process and individual investors do not get involved until the final step. Underwriters do not target an IPO to individual investors who have relatively small amounts of money to invest. The underwriters will generally focus their attention on institutional clients and offer them securities at the initial offer price.

The only way that an individual investor can be part of the IPO allocation is to have an account with an underwriting investment bank. However, even if this is the case, the account will need to be large with frequent trading in order to be considered a valuable enough client to be offered a part of a hot IPO. This means that individual investors have a very slim possibility of being part of the IPO, unless they are on the inside. When an individual investor does get shares in the IPO, it is typically an indication that no one else wanted them.

There are some exceptions to this general rule, but in the majority of cases, it is extremely unlikely that an individual investor will be able to get involved in an IPO.

Things to think about

If an investor is offered an IPO, it is important that they don’t just jump in. There are a few things that an investor should consider before purchasing shares including:

Company history can be difficult to understand even if the history is of established companies, and a company issuing an IPO will usually be even more difficult due to the lack of historical data. The main source for company information is the red herring prospectus. They will focus on the information about the company managers and the planned use of the IPO funds.

The Underwriters are the bigger brokerage firms and will usually focus on promoting successful IPOs. If an IPO is being underwritten by a small investment bank, it may be indication of a less successful company and offering.

The Lock-Up Period

Financial charts often reflect a steep downturn in the value of stocks in the few months following an IPO. This generally occurs as a result of the lock-up period. As part of the IPO, company employees and officials are required by the underwriter to enter into a lock-up agreement. This is a contract between company insiders and the underwriter that specifies the company insiders are not permitted to sell company stock for a set period. The minimum lock-up period, according to the SEC law known as Rule 144, is ninety days, however it can be much longer and is often up to 2 years. The main problem occurs when the lock-up period expires and suddenly all the company insiders are allowed to sell their securities. These people rush the market to sell to realize a profit and this excess in sales can push the stock price down.

Flipping

Flipping refers to the practice of reselling popular IPO securities immediately after purchasing them in order to make a fast profit. Flipping is not easy and brokerages strongly discourage this behavior because companies are interested in having investors who will hold the stock for the long-term period, rather than traders.

Flipping is not prohibited by law; but it may mean that a broker will blacklist an investor from being involved in future offerings. There are some double standards involving flipping because institutional investors regularly engage in this practice in order to make huge profits. Unfortunately, there is nothing to be done about this because these investors have such great purchasing power. Flipping means that it is generally regarded as unwise to purchase IPO shares that are not part of the initial offering. The IPOs may gain in the first day or two and return to a realistic level after the institutional investors have profited.

Avoiding the Hype

An important point to remember is underwriters are performing a sales role in intentionally creating hype about the offer. The fact that each company will only have one IPO means that underwriters will often advertise them as “once in a lifetime” chances for investors. It is true that some IPOs are very successful and the company shares continue to rise in value after the IPO, but many others will drop to values well below the initial offer price in their first year of trading. Investors need to think about the overall value of the investment, without being distracted by the IPO hype.

Tracking Stocks

When one company creates a new separate entity from one of its departments (a process known as a spin-off) then tracking stocks are created. The company will do this based on the principle that separating the division will create more value than keeping it as part of the larger company.

There are many advantages for the company in issuing tracking stock. They still have control over the operations of the subsidiary company, but the financial information (including all expenses and revenues) are now separate and not included on the financial statements of the parent company. A company will often do this so that a division experiencing high-growth can have its own financial data and will not be associated with large losses in the parent company’s financial statements. If there is a sudden rise in the value of the tracking stock, the parent company can use this stock rather than cash to make acquisitions.

A spin off of tracking stock may occur as an IPO, but this is different from the IPO that occurs when a company goes public for the first time. Tracking stocks investors will generally not have voting rights, and in some cases, there is not a separate board of directors responsible for the tracking stock. Although this means that the shareholders have fewer rights, it doesn’t necessarily make tracking stocks a bad investment. They are just different from a regular IPO.

About the author

Author: Mark McCracken is a corporate trainer and author living in Higashi Osaka, Japan. He is the author of thousands of online articles as well as the Business English textbook, "25 Business Skills in English".